On October 13, 2011 Spruce Point Capital Management issued a report (click here) that indicated we had major concerns with Global Sources (Nasdaq: GSOL), a Chinese B2B trade and media business. Our major points of concern are primarily focused on the company’s weakening financial prospects, opaque financial reporting, and unusual financial strategies at odds with its business model.

Recent Developments

The age-old saying “Actions Speak Louder Then Words” is particularly fitting to the situation faced by Global Sources. Since the publication of our report, the company has not made a prepared response or comment addressing the our conclusions. This has not typically been the approach taken by management teams that have been highlighted by bloggers, hedge funds, and other investors.

Take for example Silvercorp Metals (NYSE: SVM), which has taken its fraud allegations very seriously, openly communicated with investors, repurchased shares, and formed an independent committee that hired an outside forensic accountant to investigate matters (SVM news). Another approach, used by Camelot Information Systems (NYSE: CIS), our last target of investigation, was to hold a same-day investor conference call in an attempt to quell investor’s fears and halt the stock from falling farther. Our concerns about Camelot’s employee defections and business deterioration ultimately proved correct.

Is Global Source’s decision not to comment on our allegations a tacit acknowledgement that our conclusions are correct, and the stock is worth nothing more than $2.50/share? Based upon Global Source’s recent action to file a $300 million shelf prospectus on Friday, October 28th, we think the answer is a resounding "Yes." The stated intention of the filing is for “general corporate purposes” and does not appear to be justifiable on any grounds. This is yet another “red flag” that has been typically observed by Chinese RTOs: raise capital at any price and valuation before the market shuts and the game ends.

ZST Digital Networks (Nasdaq: ZSTN) is a perfect example that illustrates our point. In November 2010, we warned investors about our concerns with this company. (Source:here). The company’s management did not address the conclusions we made in the article. Instead, it proceeded to file a shelf registration for up to $50 million of capital on January 7, 2011 (Source: here). At the time, ZSTN had a market capitalization of $80m, and was reporting that it had $34m of cash on hand, and generating $18.5m of cash from operations.

Put in context, ZST’s management was indicating to investors it was willing to dilute over 60% of its market capitalization while showing elsewhere that both its cash on the balance sheet and cash from operations could more than cover the $50m shelf requirement. Ironically, ZSTN then announced on January 28th, that it would purchase office space to support its "growth" for $7.8m. (Source: here (.pdf)). Investors have since wised up to ZST’s actions, and shares have declined almost 70% since the date of the shelf filing.

What could Global Sources possibly need up to $300 million of capital for? The answer is not entirely clear, especially in light of the company’s SEC reported financials. The charts below profile the company’s reported cash balances and free cash flow (cash from operations less non-property capital expenditures). As clearly indicated by the charts, Global Sources paints the picture to investors of a healthy company, with ample cash resources and free cash flow to support the operation of its business and finance its general corporate purposes.

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Could the shelf filing be related to the Company’s recent and mysterious $50 million acquisition of property in Shanghai to support its “growth?” (Source: here). The answer is still not entirely clear because the company has yet to provide any information publicly to investors on where the property is located and if the transaction has closed.

The $300 million mixed use shelf also appears to be an incredibly large amount by any relative measure. We have analyzed its recent shelf size in comparison to other U.S. listed Chinese RTOs in the table below and illustrated the results in the following charts. To make the results comparable, we look at the ratio of the shelf size in comparison to each company’s market capitalization, reported cash balance and cash from operations for the period closest to the shelf’s filing date. Click to enlarge

The results are quite striking. Global Sources is an outlier on nearly every metric we analyze. The fact that the shelf size of $300m is greater than the company’s entire market capitalization alone is cause for serious concern.

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The cumulative stock price performance post a mixed shelf filing is unambiguous and clear. On average we should expect a 76% price decline following an unexplained shelf filing.

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Conclusion

Spruce Point Capital Management has worked tirelessly to warn investors of the problems associated with foreign companies that raise money from U.S. investors without any clear intentions. Our efforts have resulted in the delisting of companies such as China Integrated Energy (PINK: CBEH) and have helped avoid further losses in companies such as ZST Digital Networks (Nasdaq: ZSTN) and Camelot Information Systems (NYSE: CIS). The company’s lack of response to our investigative work and recent $300 million shelf filing points to greater concerns with this company than initially suggested. We believe that the conclusions previously drawn about Global Sources being opaque and not run for shareholders best interests’ are fundamentally sound. As a final reminder, “Actions Speak Louder Than Words.” We are standing behind our words, and our action has been to short the stock of Global Sources.